Key takeaways

  1. In an inflationary environment, there can be definite advantages to owning your own home vs. renting
  2. It may also be that direct real estate investments, such as owning a rental property, can benefit from inflation. This is not necessarily true of real estate-related stocks
  3. Despite inflation being high, it isn’t clear that home prices will keep rising in the near term
  4. The decision to buy a home or a rental property should be based mostly on one’s individual situation. The potential for inflation should be a minor consideration

One of the most significant financial decisions most people make is buying a home, whether it is your primary residence, a vacation home, or a rental property. With inflation running high in recent months, there is an argument that housing is a way of protecting one’s finances against inflation or possibly even profiting from it. We believe there is some merit to this argument. However, the relationship between inflation and home prices is complicated, and we would caution that it should be, at best, a minor decision in buying a home.

How inflation affects real estate

Inflation is a macroeconomic phenomenon, meaning it has an impact all over the economy at once. This macro factor is probably influencing home prices as well as rents. On the other hand, housing is also influenced by microeconomic factors, i.e., basic supply and demand issues. How much do people prefer buying vs. renting? Is the population in a given area growing or shrinking? How desirable is a certain neighborhood? How many homes are being built? What about homes for sale? These and many other micro factors often drive the housing market in a given place or even help set the price of a particular property.

This framing is important as we think about how much inflation should matter in your decision to buy a piece of real estate. While there are reasons to think that the macro effects of inflation are generally positive for home prices and generally negative for renters, it is important to remember that the micro effects can overwhelm the macro inflation effects we’re about to discuss.

Renting vs. buying

According to Redfin, the median asking rent in the U.S. has risen by 14% for the 12 months ending in June 2022. In some cities, the increase has been as much as 30%. While inflation is not the only reason why rents are rising, it is one of the more obvious ways inflation hits people’s budgets. Most leases are only signed for a year or so, so rent increases quickly hit the bottom lines of apartment dwellers. If inflation remains high, there is a chance that rents will continue to increase.

On the other hand, when one buys a home financed with a fixed-rate mortgage, the cost of housing becomes mostly fixed. In this case, the principal and interest you pay each month to the bank remain the same for the whole life of the loan. They could even go down if you get a chance to refinance your mortgage at lower interest rates.

That does not mean the costs are entirely fixed. Property taxes and homeowners insurance can rise over time, especially if the house appreciates. In addition, all homes require maintenance, which is not generally the responsibility of renters. Over time some major costs can crop up, like roof or window replacement, for which homeowners need to be prepared.

This is probably the simplest way that inflation might factor into the decision to buy a home. If you are a renter, you are subject to rents continuing to rise. Inflation isn’t the only reason why rents can rise to be sure, but all else being equal, if inflation continues to be high, odds are good that rent increases continue as well. For home buyers, this advantage is somewhat offset by other variable costs, such as maintenance.

Becoming a landlord

Owning a rental property can have a lot of financial benefits, such as a recurring income stream, potential appreciation of property value, and some tax advantages. It is also a way you can make increasing rents work for you. Typically you can get fixed-rate financing on such a property, meaning your costs are relatively fixed, and thus rising rents can increase the property's profitability over time.

That being said, buying a rental property is a huge financial decision, and we would argue that inflation protection should be seen as a secondary reason to become a landlord. At a minimum the benefits mentioned above should be weighed against the cost and hassle of property maintenance, issues related to dealing with tenants, and your financial ability to handle an extended vacancy or rent decline.

Direct real estate investment vs. buying real estate stocks

Under the right circumstances, buying a rental property can be a good investment and provide some inflation protection. You would think that buying stock in a Real Estate Investment Trust (REIT) would provide similar benefits. However, these are stocks in companies that are exclusively involved in the real estate business, and, by law, must pay out the vast majority of their profits in dividends. While REITs can be perfectly fine investments, they oft don’t convey the same inflation benefits as direct ownership of real estate. There are a few reasons for this, but it is our contention the most important is related to interest rates. 

Earlier, we mentioned that if you buy your rental property with a fixed-rate mortgage, your financing costs are fixed for the life of the loan. Large real estate companies don’t have this advantage. Take, for example, Avalon Bay, one of the largest apartment REITs in the U.S., owning 325 buildings worth just under $20 billion. The firm has almost $9 billion in outstanding debt against these properties, but it is mostly short-term debt. One-third of this debt comes due in under three years, or the interest rate is adjustable. In other words, Avalon Bay’s financing costs aren’t fixed. As interest rates rise, so will Avalon Bay’s costs. If rent increases don’t keep up, the firm will see lower profits.

Avalon Bay’s situation is similar to most REITs. This is a big reason why these stocks tend to fall when interest rates rise. This can make them a problematic investment as protection against inflation because interest rates also tend to rise when inflation is rising. These kinds of companies can be perfectly good investments overall, but we don’t suggest using them expressly to protect against inflation

Home price appreciation is complicated

It would make sense to assume home prices would tend to rise during an inflationary period. After all, inflation means prices are rising, so we'd think houses would rise too. However, given today’s circumstances, that isn’t such a sure thing. 

One reason is that home prices have already appreciated substantially since 2020. S&P Corelogic says the average home price through June 30, 2022 has risen 41% since April 2020. For context, home prices only rose 27% in the proceeding five years ending in 2019. It could be that the housing market somewhat overheated during 2020 and 2021, perhaps driven partly by historically low mortgage rates. So far, in 2022, the national average mortgage rate has jumped from 3.11% to 5.30% through June 30th, which makes the cost of buying a home significantly higher. That may weigh on home prices even if inflation continues to be high.

In general, home prices do tend to rise over the long term. Since 1987 home prices have risen 4.5% per year nationwide on average, slightly ahead of the long-term inflation rate of 2.8%. It is okay for this to be part of your calculus when buying a home. But assuming there will be outsized appreciation just because inflation is high in the near term may not be the case. It is even possible that home prices will fall a bit in the short term. 

What does this mean for you?

If you are considering buying a piece of real estate, it is reasonable to consider inflation in your calculus, however, we feel it just shouldn’t be your primary reason for making such a decision. Buying a house might make sense if you are currently renting and are concerned about future rent increases. On the other hand, if you are considering a rental property, it can be a good way of augmenting your income. We suggest making either decision based on current rental conditions and home prices. If rents continue to rise rapidly, so much the better, but we advise not to solely rely on inflation to make such a large financial decision work. 

The right team can help you think through all the ramifications of buying a house for either investment or as a home. That includes a mortgage loan officer, a licensed REALTORⓇ, and a CERTIFIED FINANCIAL PROFESSIONAL all of whom are all important to navigate different parts of what is likely to be one of the biggest financial decisions you will make.

To learn how a CFP® Professional at Facet can help you navigate the current housing market, get in touch today.